Tips for managing a systematic portfolio
This is the fifth and final article in our series looking at how you can build a systematic portfolio of shares by using the tools available at Stockopedia. In the first four articles we explored the steps that any investor needs to take in approaching the market, defining a strategy, constructing a portfolio and giving it the best chance of success. In this article we’ll look at a few of the things to think about when managing that portfolio over time.
During the series we introduced a example Systematic Value strategy to explain how a portfolio can be created. We built the strategy by merging the metrics and parameters of Joel Greenblatt’s Magic Formula and Joseph Piotroski’s F-Score. What that gave us was a focus on good quality cheap stocks that that display a strong and improving financial health. According to Greenblatt, Magic Formula stocks should be bought in batches of between five and seven every two to three months over a year (although for simplicity we made all our theoretical purchases at the same time).
The next question is when to sell? For many of us it's natural to take an active interest in how the portfolio is performing and changing and making active selling decision may seem like a critical component of being your own fund manager. But this needs careful thought because individual decisions can be costly since our human ‘fear and greed’ responses come into play. If you’re interested in implementing a systematic approach, it might be better to eliminate any possibility of your heart ruling your head by having and sticking to a strict system of periodic rebalancing.
In this series:
How to get started in the stockmarket with Stockopedia
How to create your ideal investing strategy (value, growth, dividends)
How to turn a strategy into a portfolio with Stockopedia
How to give your portfolio the best chance of success
How to manage your portfolio over the longer term
What is rebalancing?
Rebalancing involves tweaking a portfolio that has drifted away from what it set out to do when you first started. Having some sort of rebalancing strategy is essential because, over time, the make-up of all those shares in your portfolio will change – even if you do nothing. As markets rise and fall some stocks will increase substantially in value while others may fall by the wayside or even blow up. Portfolio rebalancing means that as some assets appreciate and others depreciate, you periodically adjust your positions to stay in line with your original plan. This involves taking the counter intuitive action of selling investments that are doing well. This is all tied up with the idea of mean reversion - markets and stocks tend to move in cycles, meaning that a poorly performing asset won't always do badly and a high-flyer may eventually come back down to earth.
People often tend to talk about rebalancing only in the context of how much money you have invested in bonds compared to shares, but it can equally apply to your underlying stock selection strategy. At this point, some hardened stockpickers may object “but what about running my winners” and “cutting my losers” or, put another way, doesn't this amount to the cardinal sin of averaging down? The short answer... if you fancy yourself as a stockpicker and as someone who can control their fear and greed response and time the selling of investments, you probably shouldn’t be running a systematic strategy. But it’s precisely because most people struggle to manage their emotions that systematic strategies do so well on a relative basis.
Rebalancing the Stockopedia way
We track all the 60+ Guru Models available on Stockopedia as portfolios. Like our Systematic Value example, some of these strategies may originally have been much longer-term buy-and-hold deep value strategies but - for tracking purposes at least - we rebalance all of them strictly every three months. What this means is that, every quarter, the portfolios are checked against which stocks are qualifying for the original screening criteria. If a stock is no longer qualifying, it is sold, and you use the proceeds of that sale to replace it with another stock that is qualifying.
However, this is all done on a friction-less basis (i.e. without taking transaction costs into account), which makes it viable to do the rebalancing frequently even for a smaller portfolio. In the real world, this high level of trading activity may well land you with huge trading and tax costs. Our original research into the cost effectiveness of running your own fund found that £50,000 fully invested in 25 stocks will cost around 1.96% annually to run. You can read more about that research here. That cost assumes you are buying and selling 80% of the portfolio every year which is around the average turnover rate for an institutional fund.
Annual rebalancing is likely to be optimal
The Vanguard Investment Strategy Group has done some useful work on the topic of rebalancing. Looking at US stock and bond market data from 1926 through to 2009 they found that risk-adjusted returns are not meaningfully different if a portfolio is rebalanced monthly, quarterly, or annually. However, the number of rebalancing events and resulting costs increase significantly. For that reason, they concluded that, for most broadly diversified portfolios, annual or semi-annual monitoring - with rebalancing once an investment exceeded a 5% threshold - is likely to produce a reasonable balance between risk control and cost minimisation for most investors.
This ties into the advice of other well known professional investors. Joel Greenblatt envisaged that his Magic Formula portfolio should be rebalanced annually, selling losers one week before the year-mark and winners one week after the year mark (although this guidance relates to specific US tax considerations), while the late quantitative theorist, Robert Haugen suggested that trades should be staggered monthly in 1/12th tranches so that whole portfolio is rebalanced over the course of a year rather than all at once.
The advantage of this kind of systematic rebalancing is that it entirely does away with the thorny issues about which stocks to sell and when. As Greenblatt has noted, when it comes to long-term investing, doing “less” is often “more”. Let’s say you own a stock that triples, but your rebalancing date is 11 months away. What do you do? You wait! Let’s say you own a stock that halves, but your rebalancing date is five months away. What do you do? You wait!
It is certainly true that you could miss out some potential gains and duck some losses by not taking matters into your own hands at certain times. But the question is whether you believe in the underlying system or in your own discretionary management skills?
As a quick aside, and as we discussed in the last article, the issue of diversification is essential for investors to consider and this is very likely to involve some human judgement calls. As it turned out, our portfolio also had a fairly hefty (40%) exposure to Industrials. If you’re limiting the concentration of stocks in any one industry, be sure to select new stocks from the latest lists with that in mind.
If you do decide to start making your own sell decisions more actively, there’s some great guidance from legendary investors on how to do this. At Stockopedia we have written at length on some of the theories about when investors should sell shares, both from a fundamentals perspective and a technical standpoint. Value investing legend Ben Graham suggested selling after a price increase of 50% while growth and momentum-focused US fund manager William O’Neill looks for rapid breakout, momentum stocks and bails out of non-performing duds as quickly as possible. Overall, the advice still seems to be to establish a systematic buy and sell strategy that remains steadfast to the original strategy or sets percentage thresholds that suit you – and then stick to it.
Investing tools at your disposal
In this series we have endeavoured to explain how you can become your own fund manager with the tools available at Stockopedia. From developing a strategy that matches your investment preferences to building and refining a portfolio and managing it in the long term, we have the tools to help you do it. Whether you are building your own screen from the ground up or using the tried and tested methods of some of the world’s most successful investors for inspiration, a systematic strategy has some major advantages. In particular, it can improve your decision making process by giving very clear ideas about which stocks are worth closer inspection and which should be avoided. It can also give you an advantage by taking away the risks of emotional attachment and giving you the opportunity to be contrarian with confidence.
With Stockopedia at your disposal, you can throw off the shackles of costly funds and step into the market in the knowledge that you are armed with the best data and some of the cleverest investing tools around.
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